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Thursday, September 13, 2007

I want to start by saying that, in a minor way, The Sydney Morning Herald is an employer of economics graduates from Sydney University. We hire about one every two years. Over the years we’ve hired Steve Burrell, Stephen Ellis (now a columnist from America in the Business Australian), Tom Allard, Jessica Irvine and Jake Saulwick. We’ll have another one coming on board next year. (I wish I’d hired another name you may recognise, Stephen Long of the ABC.)

The thing to note is that everyone on that list is a product of Political Economy, not the mainstream economics course. So I have pretty well-formed views about Sydney University graduates as potential employees. Why do I hire out of PE? I like PE students because PE is an essay-based course (and economic journalists have to be able to explain economics in words, not diagrams or equations), because PE students have a demonstrated interest in politics (and I regard economic journalism as a branch of political journalism) and because PE seems to attract a disproportionate share of very bright students (and I try to hire only people who are exceptionally bright).

In passing I should tell you that I don’t select trainees on the basis of the marks they got. I’m more interested in their extra-curricular activities - whether they were on the SRC, got involved in running clubs and societies, whether they wrote for Honi or the Union Record - because what I’m really looking for is people with a burning desire to be a journalist, people who’ll throw themselves into it, people who are ‘hungry’ to succeed.

I should tell you that I’m very happy with the people I recruit from PE, which is why I keep going back. In recent years, however, I’ve encountered one problem: most PE graduates haven’t actually done any courses in standard, neoclassical economics. It’s amazing, but true. This is a significant weakness and I usually have to insist that the people I hire go back and do some standard economics by distance education. I don’t think the people running PE are doing their students any favours churning out supposed economists who know less about conventional economics than someone who’d done economics at high school.

What I say to my PE graduates is that I don’t require them to believe the neoclassical model - as we’ll see, I have a lot of doubts about it myself - but I do require them to know it inside out. Why? Because the neoclassical model is the language of the public debate about economics in this country and every other country. If you don’t speak the language, you don’t participate or even understand the argument. You’re certainly in no position to convince the participants in the debate they’re barking up the wrong tree.

Of course, some of the conventional economics graduates who are whizzes at the maths aren’t good at speaking the language, either. But while I’m offering a critique of PE, let me be equally frank about the conventional course. I think its great weakness is the opposite of PE’s - it’s so busy teaching the intricacies of the neoclassical model that it doesn’t find time to give students an adequate understanding of the significant limitations of the model and the alternatives to it. To teach the model without adequately explaining its limitations is, to me, professional negligence. So there’s nothing wrong with economics at Sydney Uni that couldn’t be fixed by rolling the rival courses together - by making sure each side gets a fair dose of what the other side is teaching.

I also suspect the conventional course would be better if it devoted less time to exploring the model’s limiting cases and more to giving students practice at applying the model to specific problems. That is, after all, what economic practitioners do: apply the theory they learnt at uni to the real-world policy problems they are grappling with. But don’t get the idea from this I’m critical of the emphasis on theory in university economics courses. I’m not - not a bit. Universities should be all about theory. Theory is their comparative advantage. It’s the only thing they’re good at and they should stick to it. They shouldn’t worry about teaching vocational skills because it’s hard to learn vocational skills at uni and surprisingly easy to learn them on the job - when you get a job. It’s because economic practitioners spend their professional lives applying the theory they learnt at uni - because pretty much all the theory they know is the theory they learnt at uni - that unis should concentrate on giving their students the best understanding of theory possible. And students should concentrate on tanking up with theory while they’ve got the chance and not worry that it’s all too theoretical. The practice will come later. And when you’ve had a bit of practice you’ll realise that the theory was more useful than you thought when you were learning it.

That’s probably the most useful thing I could say to many of you: don’t sit around telling yourself how useless and unrealistic all the theory is they’re trying to make you learn. You haven’t actually had enough experience to have an informed view of what theory’s useful and what isn’t. So take your lecturers on trust: accept that if they think it’s worth teaching it must be worth learning. If my experience is any guide, when you are experienced enough to judge you’ll realise most of what they taught you was worth learning.

Of course, decent teaching of theory gives plenty of attention to teaching the limitations of the theory. So now that I turn to my topic of what’s wrong with standard theory please don’t think I’m saying economics is rubbish and you’re wasting your time with it. I’m not saying that and I don’t believe that. I could give you a speech on what’s right and useful about the neoclassical model - and if I had time I would - but instead I want to talk about the limitations of the model because that’s where I suspect the conventional course is weakest. Everything in life has strengths and weaknesses and neoclassical economics is no exception.

Perhaps before I launch in I should explain that my view of my role as an economic commentator has changed over the years. For a long time I saw myself as a sort of missionary for economics, explaining the economic way of thinking and trying to persuade people to accept the economic rationalists’ policy prescription. But that was before I’d thought more and read more about the limitations of standard economics. So now I see my role as someone paid to provide the Herald’s readers with a critique of economics and economists, just as theatre critics provide our readers with a critique of the latest plays. Economists are so influential in the debate about public policy - and they act so certain that they’re the bearers of God’s Infallible Truth - that our readers often need reminding of their blind spots and the narrowness of their advice. Of course, putting economists back in their box when I consider they’ve overstepped their area of competence doesn’t stop me still devoting a lot of time to explaining economic concepts and the motivation behind government policy positions.

I suspect the biggest problem with economics is that it split off from the rest of science - the natural sciences and the social sciences - over 100 years ago, so that while there have been many major advances in those sciences since then, economics has been in its own, self-contained world and has carried on down its own path oblivious to those advances.

In Eric Beinhocker’s recent book, The Origin of Wealth, he argues that, thanks to the work of Leon Walras and others in the 19th century, the primary inspiration for neoclassical economics was physics, particularly the physics of motion and energy. Walras introduced differential calculus to economics and the organising paradigm that the economy is an equilibrating system. But Beinhocker says economics took its inspiration from physics at a time when physicists had discovered the first law of thermodynamics, but not yet discovered the second law. As a result, economics is based on terribly out-of-date physics. It’s now clear to physicists - but not economists - that the economy isn’t a closed, equilibrating system at all, but rather an open, disequilibrium, complex adaptive system.

To quote Beinhocker, ‘when Walras imported the concept of equilibrium from physics into economics, he gained mathematical precision and scientific predictability. But he paid a high price for that gain - realism. The mathematics of equilibrium required Walras and later economists to make a set of highly restrictive assumptions that have increasingly detached theoretical economics from the real world. Traditional economics has what computer programmers call a “garbage in, garbage out” problem. If you feed a computer bad inputs, it will with absolute precision and flawless logic grind out bad outputs. Likewise, most traditional economic models begin with unrealistic assumptions and then, with mathematical inevitability, work their way to equally unrealistic conclusions. … This is why there is little empirical support for many core ideas of traditional economics, and in some cases empirical evidence directly contradicts the theory’s predictions.’

The point here is not that conventional economics is too mathematical, but that it’s not using the right maths. The right maths would, no doubt, be a lot trickier and permit a lot less precise conclusions. But I don’t want to be drawn any further on this point because, though I’ve been happy to quote Beinhocker, I don’t profess to know anything much about physics and maths.

I’m a lot more confident in pointing to another area of science where, more than 100 years ago, economics split off on its own track, so that it’s now largely oblivious to subsequent advances. That science is psychology. It was quite primitive 100 years ago, but since then has made considerable gains in understanding the drivers of human behaviour. It’s quite understandable that, with psychology being then as primitive as it was, economics built itself on the assumption that economic agents behaved rationally in all things. It was very much a product of the thinking of the Enlightenment.

But psychology’s challenge to microeconomic theory strikes at that central assumption of Homo economicus. Economic man is assumed to be rational and self-interested. He or she always carefully evaluates all the options before making any decision, and always with the object of maximising his or her personal ‘utility’ or satisfaction. But cognitive psychologists have demonstrated that humans simply lack the neural processing power to make the carefully calculated decisions economists assume. People are not rational, they are intuitive. And altruism is often an important consideration in their decision-making. People can’t chose correctly between three options where the best option is not immediately apparent. Rather than carefully thinking through the pros and cons of every decision, people tend to rely on mental shortcuts (‘heuristics’) which often serve them well enough, but also lead them into systematic biases. People are often slow to learn from their mistakes. They are frequently capable of reacting differently to choices that are essentially the same, just because the choices have been ‘framed’ (packaged) differently. This means that, rather than being coldly rational, people’s decisions are often influenced by emotional considerations.

All this means that Homo sapiens differs from Homo economicus in many important respects. He doesn’t conform to economists’ assumption of fungibility (one dollar is indistinguishable from another), he is often not bothered by opportunity cost and thus has a strong bias in favour of the status quo. He doesn’t ignore sunk costs as he’s supposed to and often can’t order his preferences consistently. He is not averse to risks so much as averse to losses and he focuses more on changes in his wealth than on its absolute level.

Unlike Homo economicus, Homo sapiens cares deeply about fairness. Experiments show people will walk away from deals they consider treat them unfairly, even though those deals would leave them better off. People are prepared to pay a price to punish others they consider to have been behaving badly towards the group. Often people are concerned about ‘procedural fairness’ – how things are done, not just how they end up.

I believe this has powerful implications for the aspect of the neoclassical model that economic rationalists (particularly right-wing rationalists) find so attractive: its elevation and celebration of individualism. The individual should be free to choose, and governments should be most circumspect in how they constrain individuals’ freedom, including by taxing them to pay for the public provision of services and to redistribute income. This elevation of the individual and, by implication, denigration of a more communitarian approach, turns out to rest heavily on the assumption that individuals are rational. If individuals are rational decision-makers then it follows, as the rationalists keep asserting, that governments can never know what is good for you better than you know yourself. Governments should therefore tax individuals as little as possible, and maximise the private provision of such things as education and health care. If individuals are not particularly rational in their decision-making, however, then there may well be a case for government paternalism in certain circumstances.

Another aspect of the non-rationality of economic agents is the way, contrary to the assumptions of the model, they aren’t rugged individualists but are heavily influenced by the behaviour of people around them. My tastes and preferences aren’t fixed, but are highly variable, influenced by what others are doing and what happens to be fashionable. I care deeply about winning the approval of others and have a great desire to fit in. At the same time I’m preoccupied with my social status. I want by my conspicuous consumption to not just keep up with the Jones but to overtake them, demonstrating my superior social standing. As my real income rises over time, more and more of it will be devoted to the purchase of positional goods. This is a particular challenge to conventional economics because, while it’s very skilled at raising the material living standards of the community generally, it’s simply powerless to do what most people would wish it to: raise their relative income. Obviously, anything it does to raise the relative income of some people will lower the relative income of just as many. Another aspect of the fact that humans are group animals is the herd behaviour investors so frequently exhibit in markets for financial assets, contrary to the contentions of the efficient market hypothesis.

Thanks to relatively recent advances in neuroscience, we now know a lot more about how our lack of rationality is a function of the way our brains have evolved. It turns out that the primitive, more instinctive, emotional part of our brain often overrides - or beats to the punch - the more recent, more logical part of our brain. This leads to a strange dualism in our minds: we’re often motivated to do things by considerations the more intellectual part of our brain knows to be silly.

It’s as though we have two selves, an unconscious self that’s emotional and short-sighted and a conscious self that’s reasoning and far sighted. We have trouble controlling ourselves in circumstances where the benefits are immediate and certain, whereas the costs are longer-term and uncertain. When you come home tired from work, for instance, the benefits of slumping in front of the telly are immediate, whereas the costs - feeling tired the next day; looking back on your life and realising you could have done a lot better if you’d got off your backside and played a bit of sport or studied harder for exams - are prospective and uncertain. Similarly, the reward from eating food is instant, whereas the costs of overeating are uncertain and far off in the future - being regarded as physically unattractive, becoming obese, becoming a diabetic, dying younger etc. As everyone knows who’s tried to diet, give up smoking, control their drinking, gambling or even speeding, save or get on top of their credit card debt, it’s very hard achieve the self-control our conscious, future selves want us to achieve. Problems of self-control are ubiquitous to modern life, but standard economics is oblivious to their existence.

Before we pass on I should acknowledge that the relatively recent school of economic thought known as behavioural economics is fully aware of the way the assumptions of standard economics fly in the face of advances in psychology and is seeking ways for more realistic assumptions about human behaviour to be incorporated into the equations of the standard model. I suspect, however, it won’t be easy.

Moving to a more mundane level, economists suffer the same problem as every other profession: what I call model-blindness - a tendency to view the world and to analyse problems exclusively through the prism of their model. To focus on those variables their model focuses on and a tendency to ignore all those factors from which their model abstracts. This is a simple error, but it’s amazing how often it’s made. It occurs partly because there is so little engagement between economists and people from other disciplines - so that economists rarely get a chance to see themselves as others see them - and partly because the teachers of economics devote so little attention to ensuring their students fully appreciate the limitations of the model.

As we’ve seen, the community is preoccupied with perceptions of fairness, whereas standard microeconomic analysis ignores equity considerations. When you press them, economists will tell you they have nothing to say on the fairness of their policy prescriptions because this involves value judgments that are beyond their area of competence. Yet it’s remarkable how often economic rationalists in particular will press policies on the community without bothering to warn people that, in reaching those policy prescriptions, they have taken no account of equity issues. This is unprofessional behaviour.

The neoclassical model focuses on one often very important factor – price – while ignoring a lot of other potentially important factors. It assumes that buyers and sellers have roughly equal bargaining power – which is often not the case. We’re hearing more about this lately as farmers and other small businesses complain about being squeezed by big business, such as the two supermarket chains. It’s been remarkable to see the Howard Government running advertisements to remind small businesses of the changes to the Trade Practices Act that now permit them to bargain collectively with big business, while at the same time using Work Choices to discourage collective bargaining between individual workers and their employers.

Another assumption of the conventional model is that both buyers and sellers have complete knowledge – about the qualities of the product being exchanged and about all the prices being charged by other sellers. In reality, sellers usually know far more about these things than buyers do, giving them a significant advantage. This ‘information asymmetry’ explains a lot of the problems and ‘market failure’ in markets. It’s what allows doctors to over-service their patients and allows the CEOs of public companies to enjoy salary packages many times greater than the value of their contribution to the firm.

The conventional model assumes away the importance of institutions – including laws and social norms of behaviour – that are critical to the efficient functioning of markets. It’s only recently, for instance, that model-blinded economists have realised the valuable role that ‘trust’ and other aspects of social capital play in lubricating a market economy. But other important institutions include the well-enforced law of contract, bankruptcy law, accounting standards and trustworthy auditors. Economists’ failure to understand this simple truth – because it’s not part of the model – led to them having a hand in some terrible disasters in recent times, such as the Asian crisis (where developing countries with utterly inadequate commercial infrastructure were urged to open their financial markets to hugely destabilising ‘hot money’ flows of foreign capital) and the badly botched transition to capitalism of Russia and other formerly planned economies.

Yet another major weakness of the model is its failure to take account of social externalities. The deregulation of shopping hours, combined with the attack on weekend penalty rates, is fast bringing about the demise of the weekend without the community ever consciously deciding this would be a good thing. Similarly, I believe Work Choices’ attack on overtime, weekend and public holiday penalty rates and provisions for the partial cashing out of holiday pay could be damaging to family life.

Then there’s the sloppy thinking that goes from the fact that economics is capable of dealing only with monetary incentives to the implicit assumption that only monetary incentives matter. This is classic model-blindness. Clearly, the real world abounds in important non-monetary incentives, including the intrinsic enjoyment of work and pursuit of job satisfaction, and the pursuit of power and status. Ignore these factors and you get wrong answers.

But perhaps the thing that worries me most about standard economics is the way its adoption of the assumption of ‘revealed preference’ - that what people do is a reliable guide to what they want - in the 1930s allowed the goal of economic efficiency to be changed from maximising utility to maximising consumption. Clearly, much utility exists outside consumption - including utility derived from job satisfaction, job security and family life. I fear this derailing of the goals of economics has turned economics into the ideology of materialism and economists into the high priests in the temple of mammon.

This at last brings me to my ostensible reason for being here, to publicise my new book, Gittinomics. What is Gittinomics - what’s my special twist on the subject? Well, most of what I’ve said today isn’t in the book. The book is a kind of exposition of how the micro economy works, but from the perspective of the ordinary person. I call it home economics. My emphasis is on understanding the system to make sure you’re a master of the market system, not a victim. Making it work for you, not you for it. To that end, the first thing to understand is the need to keep economics in perspective and economists in their place.